Gold Investment Rationale 3/01/2010“The US faces rapidly rising inflation or deflationary recession: credit cycles (and this one is extreme) always end in a deflationary bust – this is the lesson of the Kondratieff Cycle. The Fed will most likely try to defy economic gravity using increasingly inflationary means. Gold is the only asset to outperform in periods of either uncontrollable inflation or deflation: the US economy is on a knife-edge between the two.” – Redburn Partners, November, 2007.i

Investment Summary:
We think that regardless of the situation in the future, gold is a better investment vehicle than most other assets. As an inflationary hedge, it will increase in value as a proxy for the US Dollar. In a deflationary environment, gold may not appreciate, but it will outperform relative to financial investment vehicles and most other currencies.

U.S. Economic Outlook

Where we are

It’s been well documented where we are and how we got here. Here is our own two cents worth: Easy money and credit, poor regulatory decisions, irresponsible buyers and sellers, and other enabling factors have all contributed to the situation. As a culture, we have been cashing in on the hard work of generations before us. The American dream has morphed into a feeling of American entitlement. But we do not pass judgment. This is how the emotional component of economic cycles works.

It is our analysis however that the structural issues precipitating the 2008 crisis and its aftermath have remained unresolved. Simultaneously, the growing cultural austerity of our populace will be a great impediment to reflating a consumerist economy in the United States and other western economies.

Why the situation will persist

Many Cassandra-ish reasons can be made why we are all doomed. To be clear, we do not feel that way. The U.S. just has to retool how it generates income to remain competitive.ii That said, here are three major reasons we feel the U.S. economy will go nowhere significant in its current state. We are still a credit driven economy, consumers will not spend like they did in years past even if they could, and China is not ready to pick up the U.S. spending slack.

Still a Credit Driven Economy

There will be no real recovery until the economy retools itself from a consumer driven one to a capital expenditure one. This means an end to credit as a means to buy things, which won’t happen until the fed stops reanimating the easy-money cadaver.

David Roche, former Head of Morgan Stanley Research and Global Strategy, and currently president of Independent Strategy:

“….none of the core problems that caused the credit crisis have been addressed. Credit crises end when the economy starts to grow without credit. This can happen because, in a credit contraction, the price of assets and goods and services can fall dramatically. Households lose about 20% of their wealth. But if the price of things (either stuff in the shops or investments) falls by more than the combined contraction of wealth and income, they have become cheaper in terms of the ability of most households to buy them. Those with money do so. They don’t borrow to buy or invest but they have the cash. Those that don’t are still busy paying down their debts. But the ‘haves’ can have enough purchasing power to move the economy off the bottom. This sort of recovery is self-sustaining.”iii

Governments react to grass roots changes, they are not proactive. Thus, they are totally behind the curve. While this administration is busy giving easy credit to banks in the hopes it will trickle down to the public, the public has put itself on an easy-money diet. The banks aren’t helping either; they are offering to lend only to those who do not need it. The fed is just getting gamed, and monetary policy will not alter the changing habits of Americans. The credit driven method of growing this economy is dead.

Consumer Sea-Change

Consumers will resist returning to looser spending habits and will not be the engine of growth for the U.S. economy moving forward. High debt, wage pressures from a globalizing work force, and a moral rethinking of consumerist attitudes all contribute to this. It is our analysis that those who want credit cannot get it, while those with ample credit loathe to use it. No one is spending.

Roche again:

“The savings deficit countries (the US, the UK) must see a return to thrift (which will cap consumer spending). One driver of higher household thrift in deficit-ridden countries is that households and corporations realise that the wrecked balance sheets and budgets of the government sector can only be paid for in one way, down the road — with their money.”

If we are wrong and these changes do not take hold in the consumer psyche we will have a consumer-lead recovery. This is merely a can kicked down the road to the next deflationary debacle. It only affects the timing of our investments, not the choices. Deficit spending cannot be sustainable forever.

Chinese Spending will not save us

We believe the view held by some that the Chinese consumer will be a driver in this recovery is not happening anytime soon. The reasons are numerous.

* China’s recent stimulus package was intended to gear up for more export growth, not domestic consumption.
* It is a political issue for their government to let standards of living grow too much, as it will invite progressive reforms and social unrest. People will know what they’ve been missing once they see the potential.
* China, like most Asian economies after their own currency crises, is an inflation hawk. They will seek to cool down their economy more aggressively than most hope.
* Fear of a rollback to a Maoist regime still weighs on many people. These citizens keep their wealth portable, and live within their means.
* China is deepening relationships with LATAM countries to export goods, seeding the next big consumerist economy potentials

Maybe next generation folks. That said, if we are wrong and China does become a buyer of finished goods and services, U.S. inflation will explode.

What the Gov’t has done thus far

Up to now the U.S. government has embarked on a reflation attempt which will either fail and end in a deflationary crisis on par with 2008, or it will succeed and slip into an inflationary environment. The stimulus is a temporary measure at best and will only serve to delay deflationary pressures without fundamental changes in our behavior. It’s a circle of hardship. We don’t judge current actions as right or wrong. We just seek to anticipate what comes next and hopefully profit from them. And we think the choices available to the government from here are quite limited.

Government Choices Moving Forward

Not much of a choice

What must be done to combat our current paralysis and its effect on the U.S. government’s ability to repay its own debt?

Choices are limited with regards to the debt: Restructure it or devalue it. Restructuring is essentially defaulting and letting the deflationary forces run their course, and devaluing the debt consists of monetization.

U.S. Monetary and fiscal policy will continue to be geared towards devaluing its debt. Even with these attempts, more deflationary events are likely. The Greek crisis is an example. The alternative is a deflationary depression that will wipe out tax revenues entirely.

The U.S. monetary recipe

In short order we think the following will be their policies for the next several years.

* Monetary policy will remain much easier than the conventional wisdom due to a backlash against government stimulus spending. Low rates will be all they have left to make it work.
* Fiscal policy in the form of another Quantitative Easing (QE2) will be put on the table, but will have a tough chance of passing due to a trickle up of austerity from the public to its elected representatives (witness the Mass. election and the populist rhetoric to cut spending).
* Taxes will go up. No surprise here. It has already started. Wealthy families will be taxed directly, and the rest of the country will be via the companies in their portfolios getting taxed at higher rates.

The global situation does not help matters, and will only force the U.S. hand.

Economic nationalism

As a consequence of globalization, our economies are more tied together than ever. One of the factors that brought about the great depression was a nationalistic backlash against trade. The result of which was countries pulling in the reigns, drying up liquidity, and consequently deflating asset prices even more. Governments are resisting this urge today, and have learned the lessons of the past. But, banks may not care so much.

As global credit risk causes lending institutions to decrease international loan exposure, banks begin to repatriate their money and lend more locally. This is an economic nationalism, and can have the same effect as the political ones did in the 1930’s. Governments have little choice but to engage in competitive devaluations in an attempt to stave off the effects of these (localized) lending practices.

Race to the bottom

In order to attract trade away from competing countries, it behooves most governments to opt for a weaker currency. If every country knows this, then we have a prisoner’s dilemma situation. We believe there may be less honor among governments than among thieves, and a race to the bottom will be the result. Such a situation may be good for the winning individual country, but it is bad for the group and citizens everywhere. In this case, global inflation is the outcome. The countries with the most to lose are those with the most debt, and the least flexibility to deleverage. They must devalue fastest.

Conclusion

* Governments almost always choose devaluation- it is better politically, and is consistent with the kick-the-can down the road mentality of short term outlooks, limited to reelection time horizons. Some end up defaulting regardless.
* Fiscally taxes will go up, there may be a QE 2 but most of the work will remain monetary policy.
* We will either get deflation resulting in inflation or inflation resulting in deflation, but we will get both.
* 1970 Chevy Malibu carburetor analogy- the U.S. economy is an old car with a sticky carburetor. The fed’s foot has been on the gas and will continue to be until the spring loosens and the intake opens (inflation) or the spring breaks (deflation) and the intake snaps shut. Either way, the fuel system has to be fixed, because that spring is going to break soon regardless.

The only thing that remains is what to invest in, and to either time the market or just diversify risk.

Investment Choices

Moving forward we think inflation and deflation are both a risk to the markets and that the golden age of capitalistic monetary management is over. We like real estate in countries with little or no leverage on their balance sheets (personal or government), especially LATAM and Caribbean countries that may benefit not just from growing credit cycles but from an influx of wealthy U.S. and European retirees. We like seats on agricultural commodity exchanges, and we are buyers of gold in spread, physical and option form.

Before we go further, we’d like to lay out our definitions of inflation and deflation.

Inflation

Inflation is a function of monetary policy. All monetary systems can experience inflation, but paper money is most inherently prone to it. The two most popular and conflicting definitions of inflation are Keynesian and Austrian.

To oversimplify it: Keynesians believe inflation is largely demand-based and occurs when prices increase. Austrians see inflation as strictly a function of money supply, and increasing prices are merely a symptom of the problem. Either school of thought works here.

Deflation

Deflation is closely tied to fractional reserve banking. At its worst, it ends with runs on banks. People and institutions would rather have currency jingling in their pockets due to its scarcity than a debt from someone to give us money at a later date. During a panic, that is exactly what happens. Depositors see their money as a loan to their respective bank and call in the loan.

Both of these have horrendous implications for citizens. In a deflationary situation; cash is king, and everything else deflates as the word says. In an inflationary devaluation; cash is trash because purchasing power is destroyed and assets must keep pace with inflation just to justify ownership.

Gold

We like gold in a domestic inflationary environment for obvious reasons. But we also feel it will hold its own against other currencies. Gold is money, that is all. And as a store of value, it will compete with paper currencies more and more. We also believe as do others, it will increase in an almost Giffen Good manner moving forward.

Gold is also subject to fractional reserve banking. We have seen firsthand what happened in 1997 when Warren Buffet decided to take delivery of silver. The result was a backwardated spread market equal to a $40% yield annually. Unallocated gold accounts where investors have claim to a pool of vaulted gold can be subject to the same risk.

We like gold in a deflationary environment as well. Everything drops in a deleveraging, deflationary period to be sure, except currency. Gold will also most likely drop. But it will suffer the least of other assets for a couple reasons. It is money and can be easily quantified as such. It’s portable. Finally, gold is internationally recognized and understood.

We believe this all ends in a deflationary collapse and healthy economic retooling. Gold may end up being the tallest pygmy in a deflationary environment. To date we have implemented our spread strategy. We expect to accumulate a physical position over the next 60 days.